What risk you may face if you borrow too much and how to manage it?

photo credit: Andres Rueda

“There is always a price to pay for everything”

“No risk no gain”

For a real estate investment with “infinite return” as discussed in our previous article “Is it possible to have an infinite return on investment?”, the price to pay and the risk involved sometime can be significant, although supposingly you don’t need to pay a single cent in this type of investment.

Impact of interest rate hike – another power of leverage
Let’s take the real case of tan81 in the article as an extreme example since it is 100% leveraged.

If the base lending rate (BLR) bounces back to above 6.25% and his rental income is still the same (RM1450 per month), his rental property will stop putting money into his pocket but will start drawing money out from his pocket every month.

This is because every 0.1% increment in interest rate will cause an increase of RM14 in his monthly installment. His monthly cash flow from the property is around RM100 only, while every 1% increment in interest rate requires him to pay another RM140 more every month.

Unless he is taking a fixed interest rate package, otherwise he is exposed to the risk of interest rate hike. Imagine, an increase of 1% only in interest rate will require him to increase rental income by almost 10% to break even…

This is an effect of leverage. The power of leverage can help you to magnify your return on real estate investment through financing (as demonstrated by our real case in “How to increase the return of an investment property to more than 20%?”). However, it can also magnify your repayment cost even with a slight increase in interest rate, if you borrow too much for your investment property.

Managing the risk – keep your monthly installment below 60% of rental income
As discussed in our previous article “Inflation may come back soon (or it has never left?)”, if inflation strikes, which will cause the interest rate to go up, your cash flow from rental property should increase also.

However, in order to have a “robust” cash flow from your investment regardless of economy condition, we encourage for each investment property, monthly installment should not exceed 60% of the income generated from the property.

For example, if you can collect RM1000 every month from a rental apartment, keep your monthly installment below RM600, which should be enough to service a loan amount of RM130,000 with interest rate 3.75% and tenure 30 years.

This is to provide some room to maintain a positive cash flow should your bank revises interest rate to even double of the existing rate.

If you look at our rental apartment in Tampoi discussed in “How to increase the return of an investment property to more than 20%?”, we did follow the guideline of keeping monthly installment below 60% of rental income.

However, if you look at another case study from our reader in Penang (“How to turn a property to become worth borrowing/leveraging?”), which the main objective was to turn her property to become worth borrowing, you will find that if the reader borrows 90% she will not be able keep her monthly installment below 60% of her rental income.

The main reason is rental income of the property was relatively low (RM600) in this case. Because of this we suggested the reader to borrow just RM40,000 (or 38%) in order keep her monthly installment at RM184 only while increasing the return on investment from 4.23% to 6.21%.

In real life, most of the time we just can’t have the best of both worlds unless we do things right in the first place. That’s the reason why risk management is so important to every investment.

How to make sure we do things right in the first place?

Make your assumptions boldly but verify them carefully.

photo credit: me and the sysop